Are swaps forecasting a huge equity rally? (3)

Swap spreads are declining across the board, as government efforts, led by massive Fed injections of liquidity and direct purchases of commercial paper, gradually restore some confidence to the institutional money market. Think of swap spreads as a tax on transactions between major players in the fixed-income and equity markets. By late September the tax had risen to a point that transactions virtually ceased. That meant liquidity had evaporated and it left the market paralyzed with fear. The tax is gradually coming down, and liquidity and confidence are gradually returning. It is encouraging to see news reports about how money market funds are returning to the commercial paper market.

I've noted before that swap spreads tend to be leading indicators of improvements in other areas. (They don't get much attention because they are not something that the great majority of investors uses or even understands.) They accurately forecast the huge rally in corporate bonds and stocks that started in late 2002, and as this chart suggests, rising swap spreads in September were a good advance indicator of equity trouble in October. They have to come down a lot more before we're out of the woods, but they continue to move in the right direction.

Getting our financial markets back to some semblance of normality is essential to restoring the health of the economy.